How Are Dividends Taxed?

Image source: Getty Images.

Investors love getting dividends from their stock portfolios, but they don't like paying taxes on their investment income. For those who invest outside of tax-favored retirement accounts like IRAs, it's vital to know what taxes on dividends you'll need to pay. Dividend income is taxable, but for some types of dividends, the current federal tax rates on dividends in the U.S. are lower than you'll pay on other types of income, ranging from 0% to 20%. Below, we'll look more closely at how dividends are taxed and how much you can expect to pay.

Data source: IRS.

The key question: qualified vs. nonqualified dividends

The main distinction in U.S. tax law that determines how dividends are taxed is the definition of qualified and nonqualified dividends. Qualified dividends get taxed at the lower rates stated above. Nonqualified dividends, on the other hand, get taxed at your ordinary income tax rate, which varies from 0% to 39.6% depending on how much taxable income you have.

In order for a dividend to be considered qualified, it needs to meet two main criteria. First, it needs to be paid by a U.S. corporation, a corporation incorporated in a U.S. possession, or a foreign corporation that is listed on a major U.S. stock exchange. That might sound like it includes most stocks, but keep in mind that certain types of companies aren't treated as paying qualified dividends. For instance, real estate investment trusts and certain other pass-through entities typically pay out distributions that are taxed as ordinary income, rather than at preferential qualified dividend rates.

Second, you must have owned the stock that paid the dividend for more than 60 days within a 121-day holding period. The period begins 60 days before the ex-dividend date of the particular dividend in question, and it ends 60 days after the ex-dividend date. This requires shareholders to be at least somewhat long-term oriented in their thinking, preventing traders from getting tax-favored income on stocks they only hold for a few days.

Adding on a surtax

In addition to the regular federal tax above, dividend investors are also potentially subject to the Net Investment Income Tax, whether those dividends are qualified or unqualified. For single taxpayers with modified adjusted gross income above $200,000 or joint filers with AGI above $250,000, an additional 3.8% tax applies on dividend income, increasing the effective total tax rate on dividends.

Overall, the fact that qualified dividends enjoy preferential tax rates gives investing in stocks a definite advantage over other asset classes. That doesn't reduce the risk of stocks, but it does offer the prospect of keeping more of your hard-earned money for yourself.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at knowledgecenter@fool.com. Thanks -- and Fool on!